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Distressed assets in Spanish banks have declined sharply over the past five years but they remain above pre-crisis levels, the Bank of Spain says in its annual report on banking supervision.

The central bank acknowledges banks’ balance sheets are better capitalised, and the level of toxic assets has substantially fallen since 2012–13. “However, its level is still high, above that observed before the crisis,” says governor Pablo Hernández de Cos.

The overall improvement has been facilitated by the economic recovery and active management by most entities, mainly through the sale of non-performing assets, says the Bank of Spain. According to the report, from the end of 2013 to September 2018, distressed assets in the banking sector fell by 62% from €190 billion to €72 billion ($213.5 billion to $80.9 billion).

Despite this improvement, the sector still suffers from vulnerabilities. “The Spanish entities have also increased their total capital in the last four years, but they are at the tail-end of eurozone banking systems in terms of capital of higher quality,” says de Cos.

The report identifies five key challenges for banks. It says they need to find ways to accelerate the reduction of unproductive assets and strengthen their capital. In a low-yield environment, they need to improve their profitability without relaxing credit-granting standards, and reinforce the reputation of the sector by avoiding inappropriate behaviours.

In addition, Spanish financial institutions must navigate an ever-more competitive environment that is being changed by digital financial services and new competitors.

Mergers to increase profitability

In the protracted low-yield environment, many banks are operating with profitability below the cost of capital. They also face high costs associated with their organisational structure.

Against this backdrop, “mergers are a clear alternative to improve profitability and gain efficiency,” said Margarita Delgado, deputy governor of the Bank of Spain.

Delgado stressed it is not the role of the supervisor to decide which mergers are desirable or not, “but to assess to what extent a new entity, resulting from a merger process, is based on a solid business model and generates value as a whole”.

Spain is currently home to 12 systemically important financial institutions supervised directly by the eurozone-wide Single Supervisory Mechanism. They represent 91.4% of the total assets of the country’s banking system. The Bank of Spain oversees 58 smaller institutions.

In relation to the SSM’s evolution since its launch in 2014, de Cos said: “I think we can say that we are building a cohesive structure that combines the European vision with the experience and knowledge of national organisations.”

Nonetheless, he pointed out that for the banking union to be completed, it still needs “the creation of a fully mutualised deposit guarantee fund with sufficient financial backing”. Member states, however, disagree over how to set up the Deposit Insurance Fund.

Some countries, including Italy and Spain, argue the DIF will provide the final element in securing long-term stability and reducing toxic assets. Others, such as Germany and the Netherlands, consider it necessary first to reduce toxic assets further, and only then create the fund.